FAQs: Business Taxes
(Worker Classification)

I am a small business owner. Several people work for me as independent contractors. Recently, the IRS sent me a notice informing me that my workers should be classified as "employees" as opposed to "independent contractors". What are the consequences of this reclassification and what should I do now?

      Or,

I am confused about the proper way of reporting my income. I receive a 1099 Form from my employer. Can I report the income reflected on Form 1099 on my tax return as "wages and salaries"?

      Whether a worker is classified as an employee or an independent contractor has important tax consequences both for the worker and for the employer.

      From the employer's viewpoint, classifying workers as independent contractors eliminates a large amount of paperwork that otherwise the employer needs to prepare and process. In addition, when it comes to employment litigation hazards, businesses prefer the independent contractor classification because independent contractors are less likely to sue the employer under the myriad employment laws and regulations. Such laws and regulations afford broader protection to employees than to independent contractors.

      Workers usually refer to themselves as either a "W-2 employee" or a "1099 employee". This is because the employer should report the wages paid to an employee on a W-2 form while compensation paid to an independent contractor should be reported on a Form 1099-MISC. As a general rule, income from self-employment is reported on Form 1099-MISC and wages and salary of an employee is reported on a Form W-2. However, the employer's reporting preference is not determinative as to the proper classification of workers as either independent contractors or employees.

      As far as the worker is concerned, one issue is how to report his compensation: as wages and salary on Form 1040 income tax return or on Schedule C as income from self-employment. If the employer reports the compensation on Form 1099-MISC but the worker chooses to report the same income as wages and salary on Form 1040, the IRS will identify the problem as a matching issue.

      The IRS uses common law standards in order to classify workers as either "employees" or "independent contractors". Courts have identified numerous factors that should be taken into account in the classification process.

      How a worker is classified has important tax consequences. For example, an independent contractor should deduct his unreimbursed business expenses on Schedule C. If the same worker were to be classified as an employee, those expenses should be reported on Schedule A as miscellaneous itemized deductions.

      Another consequence of worker classification as either an employee or an independent contractor is the cost burden of fringe benefits such as vacation pay or sick leave. If the worker is classified as an employee, the burden is carried by the employer. This is one reason why it is more advantageous to the employer to classify as many workers as independent contractors as opposed to employees. Yet another tax consequence of worker classification is the identity of the party who pays the required contribution for Social Security and Medicare. Employees pay only half of such contribution which is also known as FICA. The other half is paid by the employer. An independent contractor, however, is responsible for the entire contribution (SECA).

      Some tax deductions are only available to independent contractors. For example, the deduction related to one-half of SECA can only be claimed by independent contractors. The favorable tax treatment afforded by the Tax Code Section 280A(c) related to home-office deduction is more readily available to independent contractors as well. Another example of advantageous tax treatment of independent contractors is deductions for business loans interest.

      Worker classification issues can entail significant tax consequences. An experienced tax attorney can help you understand and deal with the consequences of classifying workers as either employees or independent contractors. Regardless of whether you are an employee or an employer, consulting with a competent tax lawyer can result in significant tax savings and help you achieve your employment goals.